Looking for Income

Stephen Foster

It’s no secret that interest rates have been at all-time lows since their historic highs of the late 1970s. At the height of the interest rate increases of forty years ago, in the late 1970s and early 1980s, the Fed Funds rate exceeded 20 percent. The Fed Funds rate is the interest rate at which banks can borrow short-term money, usually overnight, from each other to keep the debt markets liquid. It sets the tone for interest rates in general across all interest-sensitive investments.

Bond Market Investments

During the economic collapse of 2008 and early 2009, the Fed Funds rate was zero, meaning that the cost of money was, effectively, free. Why? Because the Fed either raises or lowers rates to help stabilize the economy and induce growth; it raises or lower rates either to slow or increase economic growth. It’s a safety valve for the economy and it is used judiciously because of its power. It’s safe to say that the various Fed Chairmen and Chair Janet Yellen have been cautious and conservative over the years, as they should be, always attempting to calibrate the effect of rates on the equity and debt markets—and, by extension, the economy at large.

Altering the Fed Funds rate is a powerful economic tool: its impact on the economy is substantial and consequential.

Bond Market Investments

Which brings us to bond market investments and whether they make sense right now. The answer, wouldn’t you know it, is that it depends. It depends on what you are trying to accomplish with your investing plan. Bond interest rates differ according to the maturity of the bond in question: short-term bond maturities will typically have lower interest rates than longer-term debt investments. But the differences are not always as dramatic as you’d expect. With longer-term debt investments, you tend to be rewarded for the length of time you are willing to tie up your money.

You’d think, if you didn’t know otherwise, that the difference between 5-year Treasuries and 30-year Treasuries would be extensive. That is not necessarily the case.

For those considering bond market investments, think about this. The rate on 5-year Treasuries today is 2.26 percent. The interest rate on a 30-year Treasury bond, as of this writing, is 2.86 percent. Pause to consider. Usually, the longer the maturity of a bond the higher the rate, and usually by a considerable amount. When this is the case the bond yield curve is said to be normal.

In an inverted curve yield market, shorter-term bond rates are higher than long term bond instruments. This, of course, is counterintuitive. If you’re willing to take on a longer maturity bond, you should be rewarded by doing so: which is to say your interest rate should be higher than what it is on a short-term bond investment. Today, we are in a flat yield curve environment. This defines the illustration above: there is very little difference between yields on short- and long-term bond or debt investments. (Stock ownership is referred to as equity investing.)

So, let’s get back to the “it depends” part of this piece on bond market investments. Does it make sense to invest in bonds, given the flat yield curve we are experiencing?

If you are looking to add yield, or interest rate payments, to your portfolio it likely does make sense to put some—repeat, some—of your money in a bond investment or in an investment tied to the bond market, like a bank CD. You should know, however, that with rates as low as they are at banks these days, you’ll need to keep an eye out on inflation, which is not a major issue today. If a 5-year bank CD pays, as it does, about 3 percent, you may barely be keeping up with inflation. The current rate of inflation is slightly over 1 percent. So, given all this, your money in a short-term bond investment will beat inflation, which is a good thing.

But here’s a second view to consider. Let’s say you are investing for income, which means you are looking for interest income. If you do so through a mutual fund government securities portfolio your interest rate will likely be higher than the numbers above. Those rates fall in the 6 percent range. Not bad, given the historically low-interest rates we are experiencing now.

But remember this: bond market investments will not only pay you interest but may cause you to lose principal. Why? Because as the interest rates on bonds increase, their underlying price falls. (Exclude CDs, where your money is guaranteed, but locked up for varying periods of time.) This means that, contrary to what many investors think, you can lose money in a bond investment! If yields go up, the underlying price falls; if yields go down, the underlying price rises. Which means you can make money, too.

Here’s an example. You put your money in a government securities mutual fund with a yield, which can change daily, of 4.5 percent. Your original investment is $10,000. If rates on government securities (treasury bonds) go up, your $10,000 investment will drop. The higher the rate increase the steeper the drop. With bonds, principal and interest move in inverse relation to each other. Of course, as noted, you can avoid this by putting your money in a CD, where the principal is guaranteed not to decline—but then your money is locked up and you lose liquidity, if that’s important to you.

Stories abound about individuals who invested in the bond market for income, only to find that interest rates slipped up and the actual value of their investment dropped. Sure, the investor is receiving the higher interest rate payments, but if or when he or she decides to sell in a market such as this, they will not recover their principal investment, which has shocked more than a few investors.

The best way to view this is as follows.

Be prepared to reallocate assets as quickly as possible. You do not want to lose principal when you are investing for income, but you can do just that if you’re not aware of all the elements at work.

Also, we all know that the one thing you can’t predict is the direction of the economy.

Bond Market Investments

You need to invest both for income and growth. But don’t think for a moment your principal is protected if you invest in bonds, whether directly or through a mutual fund.

In the end, this all goes back to investing 101: know where your money is, know the consequences of that money should the economy begin to worsen, and know that you can and should make changes in consultation with your advisor.